Executive Pay

We spent a fair amount of time in b-school talking about aligning manager interests with shareholder interests. It seems like the simplest way to do that is to have the managers be owners.

I wonder how many executives would choose to stay in their jobs if their salaries were dropped to $100,000 and the Board of Directors told them if they want to make money, then they should invest their own funds in the business and they will make money when shareholders make money.

Now, I realize executive pay is a free market and a good manager is worth a good salary and much of CEO pay is really the cost cover the legal risk of being an executive, but still, I think it’s an interesting thought experiment.

It’s a thought experiment modeled after Warren Buffet, who takes a salary of $100,000 for running Berkshire Hathaway, but has become a billionaire by owning a fair size chunk of that company.

If this became the norm in executive pay, I would guess that we would see a different group of people occupying the executive suites. Speaking of executive suites, I’d bet those suites would not be as well-appointed if the managers were owners.

Now, some folks might argue that executives often do have significant portions of their pay and bonuses tied to the stock performance. On the surface, that seems like a logical way to align the interests. But, experience has proven otherwise and the explanations are simple.

For example, managers with stock options, stock grants and stocks bought with non-recourse loans from the company help align executive interests with shareholders on the upside, but not the down side. Managers personally lose nothing, except potential profits, for taking big risks to try to move the stock price up.

Not only that, but executives often have severance agreements that reward them relatively handsomely for getting fired. So, the only downside to taking big risks is the executive’s ego.

So, what happens under such pay schemes? Executives take big risks.

7 thoughts on “Executive Pay

  1. Perhaps their salaries could be based upon some base figure multiplied by the increase in some measurable set of numbers that represent the true value (as opposed to price) of the company. If the overall market is dropping (and with it the PRICE of the company’s stock), why punish the CEO if the fundamentals of the company are improving. By the same token, the CEO shouldn’t be rewarded simply because the rising tide of a bull market increases the price of the stock.

    Just my thoughts.

    • Hi Mike – I’ve seen two problems with the ‘measurable set of numbers’ approach. Those can be gamed and there really are no measurable set of numbers that perfectly align with what the market (i.e. people) is willing to pay for a stock.

      I don’t have a problem with owners being rewarded in a rising a market. Remember, in my scheme, the executives are owners. They’ve used their own money to invest. I would agree with you if they were merely rewarded in a rising market from stock options or grants.

      As for the down market, I believe if they truly are improving ‘the fundamentals’ (which, in my opinion is the long-term sustainability of the company’s earnings and earnings growth), then the company’s stock will perform better than the market and they will still do fine.

      If the stock performs with the market, then they will feel the same pain as the shareholders, as they should. Shareholders have an opportunity cost of capital. That’s the return they forgo in their next best investment to invest in your company. If an executive doesn’t rely on the value of the firm for most of his wealth, then he or she does not have that same opportunity cost of capital evaluation as the shareholders.

      Which means, if their stock is performing with the market and they really believe they are improving the company’s fundamentals, they may try a little harder to test that belief.

  2. The problems that I see with having the CEO’s reward being simply that the shares that he has invested in rise along with other shareholders is that the stock price does not always (immediately) reflect the value of the company. Having the price of your stock go down less than others in a down market doesn’t put food on the table today. A CEO may do a great job improving a company’s underlying fundamentals and yet not be rewarded if he leaves or retires before the market acts as a weighing machine rather than a voting machine.

    I do understand your point that it may be difficult to come up with a measurable set of numbers that aren’t easy for a CEO to game. Part of the reason I didn’t suggest a particular number or set of numbers is that I don’t have one off the top of my head.

    I guess the argument boils down to one of having CEOs focusing on long term value rather than short term upticks in the stock price that are not sustained.

    • Come to think of it, I’ve also see bonus systems supposedly tied to fundamentals where management got huge windfalls through no effort on their own. An external factor changed bringing in more business. So, I don’t think that is any better or worse than being tied to the stock market.

      But still, I’d rather have executives face the same incentives as owners of the firm. I know of plenty of small business owners who face ups and downs in their pay through no fault or effort of their own. When they face the downs, they scramble more and get more creative to find ways to put food on the table. It also forces them to make some very tough decisions.

      Without having that ownership incentive, they just aren’t as plugged into improving long-term value (e.g. sustainable, superior profit and profit growth).

      Ownership incentive is not perfect. I also know plenty of small business owners who run their firms to satisfy their own egos, rather than generate value — but at least it’s their own firm.

      And, in the end, I think if you had this ownership incentive in the executive suite, ultimately you’re likely to replace the bureaucrats who nurse from profit streams with real business people. Bureaucrats will seldom bet on themselves.

  3. i think this is a fantastic idea, but i can imagine a lot of resistance from your target demographic. when a company i have some interest in was ‘electing’ a new board of directors, it seemed to me that they were drawing from a relatively small talent pool – almost every board member was sitting on other boards. the ‘its not what you know, its who you know’ rule slapped me in the face. i think there arent that many ‘mailroom to boardroom’ stories for a reason, the reason seems to be that board members have a vested interest in limiting competition.

    • I agree, dave. I’ve seen the same thing. I believe the weak link in corporate governance that allows this bureaucratic cronyism to perpetuate and fester is between the distributed shareholders and the board. Shareholders have no idea who these people are, why they would make good board members because they don’t have enough vested interest to find out. They’ve diversify away their need to know. I believe this is called agency costs.

      When Buffett buys a company, he is very interested to make sure it has good business talent at the helm.

      I tired to start a wiki once that would contain bios and resumes of the board elite, so shareholders could easily see who they were voting for. But, board transparency isn’t a priority if you can just spread your bets.

      One check against that is private equity.

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